The Sustainability Signal in AQE

  • AQE creates sustainability scores for the companies we are evaluating and uses those scores to complement our other Quality metrics.
  • When tracked as a standalone signal, sustainability delivers strong results when compared with Value, Sentiment, and Quality
CIO, Active Quantitative Equity

With the COP26 conference concluding as I write this, I thought it might be an opportune time to highlight some of our thinking on “sustainability” and how it is used in the Active Quantitative Equity (AQE) team’s investment process, as well as to share some current observations about the signals and themes that markets are rewarding in the current environment.

Part of the Process

When AQE evaluates companies on one of the core themes1  that we deem most important – Quality – environmental, social, and governance (ESG) characteristics form a meaningful part of our evaluation. This is because we believe that select ESG characteristics can be considered a proxy for long-term forward planning and thinking in companies, and can signal a different kind of resilience from that which is found on financial statements.

The kinds of ESG characteristics that we take into account are generally those that would be considered material for the future financial performance of a company. Examples would include: green buildings for real estate; animal treatment policies for consumer apparel, cosmetics, or food; and bribery and corruption policies for financials.

Using these characteristics, we create sustainability scores for the companies we are evaluating and use those scores to complement our other Quality metrics, which in many (but not all) cases are gleaned from financial data. We began using sustainability in our investment process in 2013 (focusing on governance, to start with) and broadened our approach to create our current sustainability signal in 2018.

Performance and Sustainability

When tracked as a standalone signal, sustainability delivers very strong results, both over the last year and the last three years. In fact, over the last three years, when compared with our core themes (Value, Sentiment, and Quality), sustainability delivered the highest return and had the lowest volatility. So far in 2021, sustainability has had the second-highest return and the highest risk-adjusted return. See Figure 1.

Figure 1: Year-To-Date and Three-Year Returns and Volatility, by Signal
As at 31 October 2021

Are Sustainable Companies Expensive?

We don’t think so. In fact, our sustainability signal is positively correlated with our Value theme, which means that sustainable companies are more likely to be cheaper on our measures. Within the developed market universe, companies in the top quintile of our sustainability scoring are, on average, within the top 40% of our Value scoring. Companies in the worst quintile of our sustainability scoring are, on average, in the bottom 40% of our Value scoring (i.e., they are more expensive).

Sector Preferences

While many of AQE’s preferred segments (i.e., those with the highest expected returns) also have good sustainability scores, there are market segments with great sustainability scores that we don’t currently find attractive, for example, European telecoms, utilities, and real estate companies. Also, within our preferred segments there are pockets where sustainability is only average, for example, North America and APAC energy and tech stocks. See Figure 2.

Figure 2 :Sustainability Scores of Equity Market Segments

The Bottom Line

The sustainability signal clearly captures something different from the measures of Quality that we derive from financial data. Over the last three years, the correlation of the monthly returns of our sustainability signal2  with those of our broader Quality theme has been relatively low, measuring 0.2. Sustainability is a valuable characteristic to track, along with many other others. It doesn’t dominate, but it has performed solidly and with lower variability than other signals in recent years.